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FRBSF

WEEKLY LETTER

November 7, 1986

Three Views of Real Interest
After 1979, interest rates in the U.s. economy
oecamemucFi-iTiOrevOlatHe:Forexalllple,fhe
degree of volati Iity in short-term interest rates
nearly doubled. At the same time, real interest
rates (nominal rates adjusted for inflation) fluctuated around much higher levels than before.
Since 1982, however, the volatility of short-term
real rates has declined. More recently, the general level of real interest rates has tended to
diminish as well.

extent that these restrictions in the availability of
lllorfgagecredit at thrift institutions could not be
offset by other lenders, fluctuations in residential
investment were more severe.

Analysts have proposed three main explanations
for these phenomena. First, they point to the lifting of deposit rate ceilings and other types of
financial deregulation. Second is the October
1979 shift in the Federal Reserve's operating
procedures, which put more emphasis on controlling bank reserves and less on controlling
interest rates in the short run. The final explanation relates to the effects of large and growing
federal budget deficits in the United States. This
Letter discusses the theoretical relevance of
these explanations and presents some empirical
evidence to help discriminate among them.

Regulation Q ceilings also tended to reduce the
extent to which market interest rates on assets
other than mortgage loans rose during periods of
tight credit. In the extreme case where lenders
regard thrift deposits and alternative market
instruments as perfect substitutes, these market
interest rates would not rise above the level of
Regulation Q ceilings on deposit rates unless the
level of deposits were driven to zero. On the
more realistic assumption that deposits at thrifts
are regarded as imperfect substitutes for alternative market instruments by at least some depositors, a positive interest differential would be
required to attract funds away from deposits in
periods of tight credit. In this more realistic case,
market interest rates would rise as credit conditions tightened, but not by as much as they
would in a completely unregulated financial
environment.

Financial deregulation

Over the last decade, the market for mortgage

During periods of tight credit prior to 1979, Regulation Q ceilings on deposit rates tended to
restrict deposit flows into thrift institutions that
specialized in housing finance. Although commercial banks also experienced run-offs in time
and savings deposits, they were better able to
offset the effects through asset and liability
management.

credit has become more integrated with other
financial markets mainly because of financial
deregulation. Greater integration has tended
both to reduce credit availability effects on
housing and to increase the volatility of market
interest rates. A recent study conducted at this
Bank found that deposit rate ceilings and related
factors did indeed exacerbate the housing cycle
and reduce the volatility of market interest rates
to a small but measurable degree prior to 1979.
Financial deregulation was found to lessen the
severity of the housing cycle and to increase the
volatility of interest rates in a simulation that
removed the estimated effects of deposit flows in
the 1966-67, 1969-70, and 1974-75 periods of
disintermediation and which assumed an
unchanged rate of monetary growth. However,
the quantitative magnitudes of these effects were
estimated to be relatively small.

Thrifts had difficulty offsetting the lack of deposit
inflows by selling mortgage loans from their
portfolios because of a relatively undeveloped
secondary market and an unwillingness to show
capital losses. They were also slow to develop
new sources of funds and, in fact, did not issue
significant amounts of large CDs until the late
1970s. In addition, usury ceilings reinforced the
short-run tendency of mortgage lenders to ration
credit by means other than interest rates. To the

FRBSF
The simulated effects on interest rates are shown
in the chart, which compares the historical path
of the real, or inflation-adjusted, 6-month commercial paper rate over the period 1962 to 1985
with that resulting from the simulation where no
credit availability effects are allowed to operate
throughthe~ff~tts6f depbsirfl6ws.

have produced temporary increases in the level
of real interest rates until the price level had
fully adjusted to a reduced stock of money. The
slowing in monetary growth, thus, probably contributed to peaks in real interest rates from 1979
through 1982, but it cannot explain the contihuedhigh level of real interest rates since then.

The simulation shows that, in the absence of
credit availability effects, real interest rates
would have risen by somewhat more in periods
of tight credit. However, because the effects
themselves are estimated to have been quite
small, the estimated increase in the overall variability of real interest rates is also small. In the
1966 to 1975 period, the standard deviation of
the real commercial paper rate from its average
level rises from 131 basis points in the historical
observation to 141 basis points in the simulation. This small rise indicates that financial
deregulation produc~d only a 7.6 percent
increase in the volatility of real short-term interest rates.

In October 1982, when financial deregulation
and disinflation were making monetary velocity
much more unpredictable, the Federal Reserve
shifted back to an operating procedure characterized by less precise short-run control over
monetary growth. This shift provides a good
explanation for the reduction in the volatility of
interest rates that occurred after 1982. But real
short-term interest rates were still about 200
basis points higher than in the pre-1979 period.

After 1979, the actual variability of real shortterm interest rates nearly doubled. Thus, the estimated effects of financial deregulation explain
only a very small portion of the increased variability in real interest rates. Deregulation also
does not fully explain the rise in the level of real
interest rates after 1979. In the simulation,
deregulation raised the levels of real interest
rates very little, whereas the average level of real
short-term rates increased about 400 basis points
after 1979.
Monetary policy
One alternative explanation for the· increase in
the variability and level of real interest rates after
1979 is the effect of the Federal Reserve's switch
in operating procedures in October of that year.
The Federal Reserve put greater emphasis on
controlling bank reserves and less on controlling
interest rates in the short run. The new procedure should have increased the shorHun vol~
ati lity of interest rates because it meant that the
Fed would no longer tend to accommodate
short-run changes in the demand for money.

The Fed directed this new operating procedure
at slowing the rate of monetary growth to reduce
inflation. Reductions in monetary growth would

Large federal deficit
The federal budget deficit is the most important
reason for continued high
real interest rates
after 1982, and there have been two main facets
to its impact. First, larger U.S. budget deficits
tend to drive up the international level of real
interest rates. Because the world capital market
is highly integrated and securities are highly substitutable, real interest rates tend to be equated
across countries.

u.s.

u.s.

The
structural budget position (including
state and local as well as federal governments)
shifted from a surplus equal to 1.2 percent of
GNP in 1979 to a deficit equal to 2.1 percent of
GNP in 1986. At the same time, the budget deficits of other major industrialized countries have
shown little long-term trend. Thus, the net effect
of larger
budget deficits should have been
to increase the world level of real interest rates.

u.s.

Second, even in a fully integrated world capital
market, real interest rates take several years to
equalize across countries after a disturbance.
The initial effect of larger
budget deficits is
to drive up real interest rates at home compared
to those abroad. This leads to an increase in
desired net capital inflows, which generates an
appreciation of the dollar. But the interest differential in favor of the
causes the dollar to
overshootits long-run equilibrium. An expected
future depreciation of the dollar compensates for
the difference in real interest rates.

u.s.

u.s.

Deregulation Raises Interest Rate Variability
Only Slightly

highly integrated, the foreign accumulation of
u.s. debt is occurring rapidly enough that this
factor may be of some importance in holding up
u.s. real rates.

Conclusion
TheLJrll.lsLJally high level and volatility of real
interest rates after 1979 are best explained by a
combination of factors. An econometric simulation indicates that financial deregulation contributed only slightly. By producing higher peak
levels of interest rates in periods of tight credit,
financial deregulation tended to raise both the
average level and volatility of real rates, but our
estimates show these effects to be quite small.

-1

-2 L..1....L.LlJl....l-l..J!iU-.L.l_

Shaded areas represent periods of estimated credit availability effects.
"Without credit availability effects ·of regulation.

As the full effect of a dollarappreciation manifests itself in a change in the trade balance, and
thus in actual capital flows, u.s. real interest
rates then tend to fall back toward foreign levels.
u.S. short-term real interest rates remained relatively high from 1982 through 1984, but have
since dropped close to foreign real rates. This
suggests that the equalization process is nearly
complete.
The equalization process may be attenuated
somewhat by the effects of a growing accumulation of debt to foreigners. As foreigners absorb
more and more u.s. debt, they may require a
larger differential in the rate of return over
investments in their home countries. This would
reduce the size of the net capital inflows occurring in response to the u.s. budget deficit and
drive a wedge between u.s. and foreign real
interest rates. Although the weight of the evidence suggests that such differentials are small
and that the world capital market is indeed

Of greater importance have been the effects of
monetary policy. The heightened volatility of
.interest rates from October 1979 to October
1982 was due basically to the Federal Reserve's
shift in operating procedure that aimed at reducing inflation by slowing money growth. This procedure sought greater short-run control over
bank reserves. When the Fed again changed its
operating procedure in October 1982 toward
less emphasis on controlling bank reserves in the
short run, the volatility of interest rates fell significantly. Also, the Fed's disinflation policy
could have generated higher real interest rates,
but not for a prolonged period of tim~.
Real interest rates have been held at higher levels primarily by larger u.s. budget deficits. In an
integrated world capital market, U.s. budget deficits drive up the world level of real interest
rates. Since real interest rates take several years
to equalize across countries after such a disturbance, u.s. real rates tend to rise by more than
foreign rates for a while. Also, Us. real interest
rates may stabilize at a somewhat higher level
than foreign rates if foreign investors require a
higher relative return for their continued
investment.

Adrian

w. Throop

Opini?ns expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Fr~nCl~co, or of the Board of Governors of the Federal Reserve System.
EditOrial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco P.O. Box 7702 San Francisco
94120. Phone (415) 974-2246.
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments 1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Securities2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ l/Deficiency (-l
Borrowings
Net free reserves (+ l/Net borrowed( - l

Amount
Outstanding

10/15/86

10/8/86

202,723
182,101
49,754
66,811
39,478
5,617
12,639
7,982
210,243
57,180
35,468
17,773
135,291

834
911
9
131
51
1
66
143
4,426
4,6'14
965
- 114
73

46,858

Change from 10/16/85
Dollar
Percent?

Change
from

483

33,136
26,981

-

-

-

-

-

5,775
4,281
919
1,418
1,704
228
810
681
5,920
5,319
11,831
3,475
2,872

-

445
605

5,287
2,528

Period ended

10/6/86

9/22/86
20
27
7

1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities

Excludes U.S. government and depository institution deposits and cash items
ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change
3

4

-

1,515

Period ended

36
24
12

-

2.9
2.4
1.8
2.1
4.5
4.2
6.8
9.3
2.8
10.2
25.0
24.3
2.0
3.3

-

13.7
10.3